Question

Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,240,000 and will last for 5 years. Variable costs are 35 percent of sales, and fixed costs are $147,000 per year. Machine B costs $4,360,000 and will last for 9 years. Variable costs for this machine are 31 percent of sales and fixed costs are $109,000 per year. The sales for each machine will be $8.72 million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis.

(a)	If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine A? (Do not round your intermediate calculations.)

(b)	If the company plans to replace the machine when it wears out on a perpetual basis, what is the EAC for machine B? (Do not round your intermediate calculations.)

Answer 1

Using the bottom up approach, or net income plus depreciation, method to calculate OCF, we get:

	Machine A	Machine B
Variable costs	-3052000	-2703200
Fixed costs	-147000	-109000
Depreciation	-448000	-484444
EBT	-3647000	-3296644
Tax	1276450	1153826
Net Income	-2370550	-2142819
+ Depreciation	448000	484444.4
OCF	-1922550	-1658374

The NPV and EAC for Machine A is:

NPV_A= –$2,240,000 - $1,922,550 (PVIFA 10%,5)

NPV_A= –$2,240,000 - $1,922,550 * 3.790787

NPV_A = –$9,527,977.10

EAC_A= – $9,527,977 / (PVIFA10%,5)

EAC_A= –$9,527,977 / 3.790787

= -$ 2,513,456.36

The NPV and EAC for Machine B is:

NPV_B= –$4,360,000 - $1,658,374 (PVIFA 10%,9)

NPV_B = –$13,910,617.92

EAC_B= – $13,910,618 / (PVIFA10%,9)

EAC_B= –$13,910,618 / 5.75902

= -$ 2,415,447.19